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Income Tax Appellate Tribunal, DELHI BENCH ‘I-2’ NEW DELHI
Before: SHRI N.K. BILLAIYA & SHRI SUDHANSHU SRIVASTAVA
ORDER PER SUDHANSHU SRIVASTAVA, JUDICIAL MEMBER:
This appeal is preferred by the assessee against the order dated 18.11.2014 passed by the Learned Commissioner of Income Tax (Appeals) {Ld. CIT (A)} and pertains to Assessment Year (AY 2009- 2010.
2.0 Brief facts of the case are that the assessee is engaged in the business of manufacturing and sale of specific governors and engine controls for Indian Railways and other customers. It also provides after sales service for a wide range of industrial controls.
(Woodward India Pvt. Ltd.) For the subject assessment year, the Transfer Pricing Officer (TPO), vide order dated 30.1.2013, made an adjustment amounting to Rs.3,98,05,532/-in respect of international transactions pertaining to royalty and technical know-how being paid by the assessee to its Associate Enterprises (AEs), namely, Woodward Governer Company, USA. The assessee’s grounds of appeal before the Ld. CIT (A) were dismissed and now the assessee is in appeal before this Tribunal (ITAT) and has raised the following grounds of appeal:
That on the facts and in the circumstances of the case and in law, the order passed by the Ld. Assessing Officer (“AO”) is bad in law and void ab-initio.
That the reference made by the Ld. AO suffers from jurisdictional error as the Ld. AO has not recorded any reasons in the assessment order based on which he reached the conclusion that it was “expedient and necessary” to refer the matter to the Ld. TPO for computation of the arm’s length price, as is required under section 92CA(1).
That on facts and circumstances of the case and in law, the Ld. AO/Ld. Transfer Pricing Officer (“TPO”)/ Ld. Commissioner of Income Tax – (Appeals) (“CIT-A”) erred in making an addition of Rs. 39,805,532 to the returned income of the Appellant by re-computing the arm’s length price of the international transactions under section 92 of the Act.
(Woodward India Pvt. Ltd.) 4. That on the facts and in the circumstances of the case and in law, the Ld. AO/ Ld. TPO/ Ld. CIT-(A) erred on facts and in law in determining the arm’s length price of the international transactions of royalty and technical know-how fees of the Appellant as nil by:
4.1 by not taking cognizance of the business operations of the Appellant along with its functional and risk profile and thereby treating the payment for royalty and technical know-how as unjustified without considering the benefits derived from the technical assistance received and underlying evidence thereof and hence challenging the commercial wisdom of the Appellant’s business operations; 4.2 by not appreciating that the transactions are closely linked and intrinsic to the business operations of the appellant and arbitrarily rejecting the application of Transactional Net Margin Method as the most appropriate method of benchmarking the impugned transactions; 4.3 by erroneous application of Comparable Uncontrolled Price method without furnishing details of price charged in any comparable uncontrolled transaction which is in contravention of the provisions of Rule 10B of the Rules.
That the adverse findings given by the Ld. AO/ Ld. TPO/ Ld. CIT-(A) are contrary to the evidence on record and their conclusions are based on surmises.
That on the facts and circumstances of the case and in law, the Ld. CIT-(A) erred in not deleting the disallowance made by the Ld. AO on account of warranty expenses amounting to Rs. 2,659,823.
6.1 That on the facts of the case and in law, the Ld. CIT-(A) erred in not accepting the contentions of the Appellant that the entire expense on account of warranty, amounting to Rs. 7,833,396 should be allowed to the Appellant, and accordingly erred in directing the Ld. AO to re-compute the provision for warranty in accordance with the directions of the Hon’ble Delhi High Court for AY 2005-06 and 2006-07.
6.2 That on the facts of the case and in law, the Ld. CIT-(A) erred in not appreciating that the entire actual warranty expenses amounting to Rs. 3,720,158/- charged directly to profit & loss account during the year should be allowed to the Appellant as no provision for warranty was created in respect of the same during the year.
6.3 Without prejudice to Ground No. 6.2 above, the Ld. CIT-(A) also erred in not accepting the proposition that actual warranty expenses amounting to Rs. 3,720,158 charged directly to profit & loss account during the year should be given effect to and adjusted while computing the closing provision for warranty to be carried forward to subsequent year.
6.4 The Ld. CIT-(A) also erred in not accepting the proposition of the Appellant that the opening provision of warranty brought forward from the earlier year should be computed in accordance with application of the rectification filed in the AY 2005-06 & 2006- 07 and the actual expenditure of actual warranty expenses (Woodward India Pvt. Ltd.) incurred and charged to profit & loss account in the assessment year 2007-08 amounting to Rs. 3,078,892 should be taken into account.
That the Ld. AO/Ld. CIT(A) erred in facts and in law in withdrawing interest under section 234D of the Act.
That on the facts and circumstances of the case and in law, the Ld. AO has erred in initiating penalty proceedings under section 274 read with section 271(1)(c) of the Act, for disallowances made under section 92CA(3) and provision for warranty, mechanically and without recording any adequate satisfaction for such initiation.
3.0 The Learned Authorised Representative (Ld. AR) submitted that Grounds of appeal Nos.1 to 3 were general in nature requiring no specific arguments.
3.1 With respect to ground nos. 4 and 5, it was submitted that during the year under consideration, the assessee had obtained technical know-how and expertise for manufacturing a new product, i.e, 18 mm Alco Fuel Pump. It was submitted that as consideration for the supply of technical know-how received, the assessee paid a lump sum fee amounting to Rs.3,39,34,585/- to its AEs. As a further consideration for the supply of technical know-how and for other rights granted by the AEs, the assessee also paid royalty amounting to Rs. 58,70,947/-. It was further submitted by the Ld. AR that as per the agreement dated
(Woodward India Pvt. Ltd.) 27.3.2008, along with the amended agreement dated 30.03.2008, between the assessee and its AEs (placed at paper book Page 321 to 334), the assessee paid Royalty at the rate of 5% of the net ex- factory sales price of the products manufactured and sold in India and at the rate of 8 percent of the net ex-factory sales price of the products manufactured and sold outside India. It was further submitted that effectively, the actual pay-out towards royalty for the impugned year was 1.73% (i.e., royalty paid during Financial Year 2008-09 Rs 58,70,947/- Manufacturing segment sales Rs. 33,94,64,391/- ).
3.2 The Ld. AR submitted that for the purpose of determination of the Arm’s Length Price (ALP) of the transactions pertaining to royalty and technical know-how, the assessee followed the segmental approach, applied Transaction Net Margin Method (“TNMM”) and aggregated the technical know-how and royalty payments with the overall margins of manufacturing segment. It was submitted that by applying the TNMM method, operating profit margin on sales (“OP/ OI”) was considered the most appropriate Profit Level Indicator (“PLI”).
3.3 It was further submitted by the Ld. AR that in the manufacturing segment, the assessee earned OP/OI of 9.25% 6 | P a g e
(Woodward India Pvt. Ltd.) with respect to the manufacturing activities (pages 454-455 of paper book volume II) and the average OP/OI of the comparable companies was determined to be 11.98% (updated margins of comparable companies produced at page 360 of paper book volume II). The Ld. AR submitted that the margin of the assessee as per the proviso to section 92C (2) of the Income Tax Act, 1961 (hereinafter called ‘the Act’), was within (+/-) 5% range (page 428 of paper book volume II).
3.4 The Ld. AR submitted that the TPO disregarded the ALP as computed in the documentation and the submissions filed during the assessment proceedings and applied Comparable Uncontrolled Price (“CUP”) method as the most appropriate method. It was submitted that the TPO did not dispute the receipt of expertise and know-how received from AE, but, however, concluded that no benefit was derived from such know- how received by holding that no unrelated party would make a payment for such services. Thus the ALP was determined as Nil by the TPO and the same was upheld by the Ld. CIT (A).
3.5 Coming to the issue specific to this appeal, the Ld. AR submitted that during Financial Year (FY) 2008-09, the assessee had received technical know-how for a new product, i.e. 18 mm
(Woodward India Pvt. Ltd.) Alco style fuel injection pump, which were supplied to Indian Railways for use in their 3100/3300 HP diesel locomotive engines. This was necessarily required by the assessee as its primary customer, the Indian Railways, sought the part for better efficiency and performance of its engines. It was submitted that this demonstrates that access to this technology was a business requirement in order to remain competitive in the market. It was submitted that with a view to demonstrate the requirement set forth by Indian Railways, the assessee furnished a letter by the Indian Railways before the lower authorities wherein such part was sought from Woodward India (page 153 of paper book volume I).
3.6 It was also submitted that the growth of Woodward India’s sales was in a large way dependent on the Indian Railways as during this year, the assessee was primarily selling only to the Indian Railways and, therefore, the assessee company had no option but to comply with the demand in the market in order to function competitively. It was vehemently argued by the Ld. AR that in this case: a) technical know- how was received; b) technical know- how was utilised by the assessee to make sales;
(Woodward India Pvt. Ltd.) c) sales were made to the customer that necessitated the acquisition of the technical know-how.
It was reiterated that all the aspects of receipt, benefit as well as commercial requirements of entering into this inter-company agreement are evidenced in the present case.
3.7 It was further submitted by the Ld. AR that to enable the manufacturing of the new product, the assessee received from its AE (as per the Agreement), technical know-how like documents in the nature of drawings, specifications for manufacture, testing and repair of products, quality assurance manuals, product technical manuals, standards, technical records, material lists, process manuals and all other technical data, information, formulae and knowledge relating to the products (pages 327 and 344 of paper book volume I for Agreement). It was submitted that the assessee had received technical assistance such as: a) Assistance in setting-up of plant: Assistance in setting up the plant for the manufacture of the products by Woodward India including providing of information; b) Training: Training of employees in its plants of its AE. Such employees are trained in the function of manufacturing and testing of the products and no separate charge was levied for this;
(Woodward India Pvt. Ltd.) c) Intellectual Property Rights : IPR right to manufacture the products which includes patent rights; d) Technical support: Technical support in case required.
It was submitted that in order to substantiate the above, the assessee has provided documentary evidences at pages 18-72 and 145-166 of the paper book.
3.8 The assessee further submitted that the assessee has filed the following evidences to substantiate the technical know- how received during the year:
I. Drawings: Necessary for manufacture of fuel injection pump.
Minute details of the fuel injection pump were given and explained in this diagram. It gives information about each and every part, the knowledge of which is necessary for its assembly and maintenance and effective functioning of Woodward India (refer page 74 of paper book volume I).
II. Product manual: This served as a maintenance manual as well. It gives the complete details about the dismantling, examination and assembly procedure of the fuel injection pump.
The manual also talks about pump calibration and testing procedures, its spares lists etc. (pages 76-99 of paper book volume I).
(Woodward India Pvt. Ltd.) III. Quality assurance manual: This manual is applicable to all Woodward sites and businesses and outlines the policies, processes, and requirements of the quality management system requirements set forth by ISO 9001, Aerospace Standard AS9100, Woodward customers and applicable Regulatory Authorities (pages 101-129 of paper book volume I).
IV. Test specifications: These wererequired for the effective functioning of the fuel pump which enhances the performance of the fuel pump. This manual ensures proper testing of the pump before and after assembly of the same (pages 130-144 of paper book volume I).
V. Technical manual: The technical manual consists of a maintenance manual and a service instruction manual which provides guidance about the practical aspects of Fuel Injection Equipment operation and service (pages 167-214 of paper book volume I).
VI. Bill of Material and Drawings: The Bill of Materials and drawings which is required for the successful assembly of the fuel injection pump. The drawing and specifications of each of the spare part mentioned in the bill of material were also provided for guidance and support (pages 215-266 of paper book volume I).
(Woodward India Pvt. Ltd.) VII. Testing Procedures: In Process Inspection Check Sheet’ and ‘Finished Product Inspection Test Specification were also submitted, which proves that AE has also helped with the testing procedures which were absolutely necessary for the success of the new product (pages 267-298 of paper book volume I).
3.9 It was, thus, vehemently argued by the Ld. AR that the allegation of the TPO that no tangible benefits have been received by the assessee and as upheld by the Ld. CIT (A) was incorrect.
3.10 To further buttress his arguments, the Ld. AR submitted that the TPO has focused merely on the profitability trend of the assessee as evidence of economic benefit. In this regard, it was submitted that the technical know-how and technology received from AE contributes to the increased sales of the assessee as is evident from the table below:
Year-on- FY Total Sales Year-on- Sale of 18mm Alco Year growth (INR) Year Style Fuel Injection growth Pump - 2008-09 67,48,09,678 - 28,49,891 987.05% 2009-10 81,79,40,213 21.21% 3,09,79,781 90.15% 2010-11 1,18,17,95,412 44.48% 5,89,08,364 2011-12 1,12,95,92,319 3,10,32,079 3.11 Further, the margins of the manufacturing segment of the assessee were also provided as under:
(Woodward India Pvt. Ltd.) OP/OI of the manufacturing Year segment FY 2008-09 9.25% FY 2009-10 9.33% FY 2010-11 10.64% FY 2011-12 17.34% 3.12 It was further submitted that the decline in its margins vis-à-vis the prior year(s) is because of pricing pressures and other market factors rather than inter-company payments. This is evident from the fact that if the assessee had not received this technology from AE, it would not have been able to manufacture the products and execute any sales at all. In that case the assessee would have to invest in-house in developing the technology, which would have been counterproductive and expensive for its scale of operations.
3.13 The Ld. AR submitted that the sales registered by the assesseee were with the third parties and, thus, a decrease in the sales would ultimately result in a decrease in the margins. A chart comprising product wise details of sales of manufactured goods was also provided as under:
FY 2008-09 FY 2009-10 FY 2010-11 In % Amount Amount In % terms Amount In % terms terms Manufactured goods sales PGEV Governors 92,993,129 27.41% 68,382,020 20.04% 0% -
(Woodward India Pvt. Ltd.) Governors/ Controls for other 3,093,453 0.91% NA NA NA NA diesel engines Steam Turbine 156,192,099 46.04% 139,313,647 40.82% 145,876,256 44.85% control systems Others 84,144,193 24.80% 102,593,313 30.06% 120,478,142 37.04% Fuel Pump 2,849,891 0.84% 30,979,781 9.08% 58,908,364 18.11% 3.14 It was further submitted by the Ld AR that the assessee company has made sales for the 18 mm Alco style fuel injection pump beyond the year 2012 also, whereas, the value of the technical know-how was fully amortized in Financial Years 2008- 09 and 2009-10 itself. It was submitted that, thus, the assessee continued to garner the benefits of the technical know-how by way of increased sales during several years, while the cost was incurred only in Financial Years 2008-09 and 2009-10.
3.15 It was further submitted by the Ld. AR that the TPO has nowhere clarified as to why economically or commercially similar transactions that were made to obtain the technical know-how for manufacturing a product should be considered to be a separate business activity or a separate class of transaction. The Ld. AR argued that the TPO while proceeding to apply CUP method has not provided any data on prices charged or paid by comparable independent entities for similar transactions and, therefore, the applicability of CUP method by the TPO is incorrect.
(Woodward India Pvt. Ltd.) 3.16 The Ld. AR submitted that it is the case of the assessee that technical know-how and royalty payments are inextricably linked with production and sale of products. If there were no production and sales, there would be no question arising regarding payment of any technical knowhow/royalty. The Ld. AR reiterated that the payments made for technical know-how and royalty was closely linked with production and sales and cannot be segregated from these activities of the Assessee and that these payments were an integral part of the manufacturing operations of the Assessee and were closely and intrinsically linked.
3.17 It was also submitted by the Ld AR that even after making payments for royalty and technical know-how, the Assessee has earned a profit margin which is comparable with the arm’s length profit margin of comparable companies (pages 328 and 454 of the Paper Book for the margins of comparable companies and the Assessee).
3.18 Reliance has been placed by the Ld. AR on the following decisions, wherein royalty payments have been held to be intrinsically linked to the main transactions and aggregation approach to benchmark the same has been upheld:
(Woodward India Pvt. Ltd.) • Magneti Marelli Power Train India (P) Ltd vs. DCIT [2016] 389 ITR 469 (Delhi). The SLP filed by the Revenue authorities against the judgment of the Hon’ble Delhi High Court has been dismissed by the Hon’ble Supreme Court [2018] 89 taxmann.com 8 (SC); • Frigoglas India (P) Ltd vs. DCIT [2016] 68 taxmann.com 370 (Del-Trib.), upheld by the Hon’ble Delhi High Court vide order dated March 3, 2017 (ITA 123/2017). SLP filed by the Revenue authorities has been dismissed by the Hon’ble Supreme Court vide order dated January 19, 2018 (SLP (civil) No. 41702/2017); • Cummins India Limited vs. Addl. CIT [2015] 68 SOT 14 (Pune Tribunal.); 3.18 Further reliance was also placed on the following decisions wherein it has been held that the TPO is to conduct a transfer pricing analysis and determine ALP in accordance with law and that the TPO cannot determine whether there is a service from which the assessee benefits or not and, therefore, the TPO cannot determine the ALP of payments made by an assessee to its AE as NIL taking a view that no benefit was derived: • Frigoglas India (P) Ltd vs. DCIT [2016] 68 taxmann.com 370 (Del-Trib.), upheld by the Hon’ble Delhi High Court vide order dated March 3, 2017 (ITA 123/2017). SLP filed by the Reenue
(Woodward India Pvt. Ltd.) authorities has been dismissed by the Hon’ble Supreme Court vide order dated January 19, 2018 (SLP (civil) No. 41702/2017) • CIT vs. EKL Appliances Ltd. [2012] 345 ITR 241 (Delhi) • COIM India Pvt. Ltd vs. ACIT (ITA No. 7260/D/2017) (Delhi – Trib.) 3.19 The Ld. AR further submitted that the decision to enter into any transaction is Assessee’s commercial decision, and it is not open for the Revenue to question the commercial prudence. The Ld. AR submitted that the Revenue cannot sit and judge over the manner in which the Assessee needs to run its business and that the decision of the Assessee to avail services is based on its own judgment of commercial expediency and the Revenue cannot purport to place themselves in the shoes of a business person and assume a role to decide whether a particular expenditure needs to be incurred or not. Reliance in this regard was placed on the following decisions: • CIT vs. Dhanrajgirji Raja Narasingir (1973) 91 ITR 544 (SC) • CIT vs. Walchand and Co (P) Ltd. (65 ITR 381)(SC) • CIT vs. Dalmia Cement Ltd (254 ITR 377)(Del) • S.A. Builders Ltd. vs. CIT and Anr. (289 ITR 26)(SC) • EKL Appliances Limited vs. CIT [2012] 345 ITR 241 (Del)
3.20 Lastly, the Ld AR drew our attention to the fact that similar royalty and technical payments have been accepted by the AO/TPO in subsequent years. In this regard, he relied on the below tabulation:
AY TPO DRP Remarks
2010-11 Adjustments in respect of Adjustments in respect of No fee for technical knowhow fee for technical knowhow intimation and royalty were made. and royalty were deleted. of appeal (pages 1-11 of paper book (pages 12-21 of paper book filed by comprising orders of comprising orders of Revenue subsequent AYs) subsequent AYs) authorities 2011-12 No adverse inference drawn by TPO in respect of any international transaction (pages 38-39 of paper book comprising orders of subsequent AYs)
2012-13 No adverse inference drawn by TPO in respect of any international transaction (pages 40-41 of paper book comprising orders of subsequent AYs)
2013-14 No adverse inference drawn by TPO in respect of any international transaction (pages 42-43 of paper book comprising orders of subsequent AYs)
3.21 In view of the above, it was prayed by the Ld. Counsel that the disallowance of payments made for royalty and technical know-how received was unwarranted and deserved to be deleted.
4.0 The Ld. Department Representative (“CIT DR”) strongly countered the submissions of the Ld. AR. The Ld. CIT DR submitted that the TPO has rightly computed the ALP as Nil of (Woodward India Pvt. Ltd.) the payments made in relation to royalty and technical knowhow by applying the CUP method. It was submitted that the Assessee has not been able to substantiate the benefits received out of such payments made. The Ld CIT DR placed reliance on the orders of the lower authorities and prayed that the same deserves to be upheld.
5.0 We have heard rival submissions and perused the material on record.
5.1 Ground Nos. 1 to 3 are general and do not require any specific adjudication.
5.2 As far as Ground Nos. 4 and 5 are concerned, the case of the Assessee is that it has made a payment to the tune of Rs. 3,98,05,532/- in relation to royalty and technical know-how for the new product, i.e. 18 mm Alco Fuel Pump required by Indian Railways as per specific demand for the customer. Our attention was drawn to the letter received from the Indian Railways for such Fuel Pump requirement from the Indian Railways. In addition to the letter placed on record which was received from the Indian Railways, the Assessee has filed voluminous documents, inter alia, agreement with the AE for receipt of technical know-how, such as, drawings, product manuals,
(Woodward India Pvt. Ltd.) quality assurance manuals, test specifications, technical manuals, bill of material and drawings and testing procedures as mentioned elsewhere in the order. Perusal of the voluminous documents filed, orders of the lower authorities and the legal position emanating from the various case laws cited, it is manifested that the TPO is obligated to determine the ALP of international transactions by using one of the methods prescribed in Rule 10B of the Income Tax Rules, 1962 (the ‘Rules’) and the lower authorities have failed to do so.
5.3 Moreover, it can be seen that neither the TPO nor the Ld. CIT (A) has discarded the most appropriate method adopted by the Assessee which was TNMM in the present case for benchmarking the manufacturing segment. Facts on the record also show that the TPO has not discarded the exercise undertaken by the Assessee in determining the ALP of the international transaction related to royalty and technical fees by using the aggregate approach and benchmarking it with manufacturing segment. We find force in the arguments of the Ld. AR that where the assessee had used TNMM to benchmark all its transactions and the TPO having accepted TMNN as the most appropriate method, it was not open to the TPO to subject
(Woodward India Pvt. Ltd.) only one element, i.e. payment of technical assistance fee, to an entirely different method (CUP) as this would lead to chaos and be detrimental to the interests of both the assessee and the revenue. For this, we draw support from the judgment of the Hon’ble Delhi High Court in the case of Magneti Marelli Powertrain India (P) Ltd. vs. DCIT reported in (2016) 389 ITR 469 (Del.) wherein the Hon’ble Delhi High Court has upheld the finding of the Delhi Tribunal in Magneti Marelli Powertrain India (P) Ltd. vs. DCIT reported in (2014) taxmann.com 155 (Delhi – Trib.).
5.4 We also find it appropriate to mention that the TPO, in the subsequent years, has accepted the aggregate approach and the TNMM method as against the approach of the TPO in this year to benchmark the transaction separately. The TPO has arbitrarily applied CUP, which is not supported by the approach of the TPO in the subsequent years.
5.5 In our considered opinion, the view of the lower authorities that the benchmarking done by the Assessee is incorrect and the approach of the TPO, as has been upheld by the Ld. CIT (A), is not sustainable. Our view is also supported by comparison of margins of the Assessee with the margin of the (Woodward India Pvt. Ltd.) comparable companies. As stated elsewhere in the order, the Assessee has earned the margin of 9.25% with respect to manufacturing activities as against the margin of 11.98% earned by the comparable companies. Thus, the Assessee’s margin is within the (+/-) 5% range.
5.6 Therefore, looking from any angle, the approach of the Assessee is correct in so far as it relates to the payment of Royalty and Fee for Technical know-how and the adjustment amounting to Rs. 3,98,05,532/- in relation to international transactions pertaining to payments for royalty and technical know-how deserve to be deleted. It is so ordered accordingly.
5.7 Ground No. 6 has not pressed by the Ld. AR. The same is dismissed as not pressed.
5.8 Ground Nos. 7 and 8 are consequential and require action at the end of the AO while giving the appeal effect.
6.0 In the final result, the appeal of the assessee stands partly allowed. Order pronounced in the open court on 25th March, 2019.